How to Profit from the Developing Shift in the Natural Gas Market - Interview

Here's the situation: North America is swimming in cheap natural gas, whereas international markets are thirsty for it and paying a premium. Now that the DOE is beginning to approve LNG export permits, North American producers have major incentive to drill, baby, drill. To get an expert perspective on the coming LNG supply shift, The Energy Report turned to Cantor Fitzgerald Analyst Sam Wahab, who keeps tabs on global oil and gas developments from his base in London. This is a must-read interview for anyone who wants to profit from a potentially massive shift in natural gas fundamentals.

The Energy Report: Sam, how will an increase in the export of liquefied natural gas (LNG) from the U.S. affect the price of that increasingly abundant commodity?

Sam Wahab: LNG export potential is a very hot topic at the moment, given the significant disparity in gas prices in the U.S. and almost everywhere else in the world. Depressed U.S. gas prices provide an investment opportunity. Low prices have already contributed to a resurgence in the U.S. petrochemical industry. Utility companies are shifting away from coal to using natural gas for electricity generation. If the U.S. becomes a major exporter of LNG, there will be good opportunities for companies with expertise to make strategic acquisitions.

The push to export natural gas stems from the fact that the U.S. simply has too much of it. Thanks to the fracking-led energy boom, U.S. natural gas prices have collapsed. Many recently drilled wells have been shut down because pumping costs more than the gas can be sold for in the market. But gas prices in other parts of the world are not nearly so low. In Europe, gas prices are five times higher than in the U.S. That disparity offers an incredible incentive for energy companies to put their gas on a ship and send it abroad.

TER: Are there any other political and economic obstacles to ramping up U.S. exports?

SW: The Department of Energy has 20 export applications pending. Most of the applications are from smaller firms, but the facilities can be used to ship gas for big oil companies, including BP Plc (BP:NYSE; BP:LSE), Royal Dutch Shell Plc (RDS.A:NYSE; RDS.B:NYSE), Exxon Mobil Corp. (XOM:NYSE), or Chevron Corp. (CVX:NYSE). The government has been taking a cautious approach on exports. The Energy Information Administration reports that as natural gas exports increase, gas prices may rise between 3–9% which translates into a 1–3% increase in utility bills for residential consumers. Overall, manufacturing job losses due to increased exports should be minimal, and should be more than offset by the positive economic effects of increased drilling and greater export revenue.

American manufacturers remain concerned that too much export could drive up the price of natural gas, which is a key energy source for making plastics and polymers and industrial chemicals. But manufacturers have recently launched more than 100 new projects designed to take advantage of America's low natural gas prices, and they have invested billions of dollars creating half a million new jobs. Going forward, manufacturers claim that 5 million jobs could be on the line if exports are not handled properly, although they are cautiously comfortable with the fairly slow pace of export approval. No one expects that all 20 permits will be approved.

TER: American consumers are used to cheap natural gas. Do you see a backlash if prices increase?

SW: I do not see prices increasing significantly unless exports are rolled out on a large scale. America is sitting on more gas than it is going to use domestically for quite an extended period of time. There will be a squeeze on the end-consumer if prices do rise, but I do not expect a huge backlash. The U.S. consumer has enjoyed an extended period of low gas prices following the U.S. shale boom: All things must come to an end.

TER: Is an increase in the possibility of massive U.S. exports of liquid natural gas a positive sign for junior explorers and producers in North America and Europe?

SW: Access to a large market with higher spot prices will always be positive for junior explorers in the U.S., as that will invariably increase the commerciality of exploration and development. This is especially important following the long period of consolidation in the U.S. market, and the dramatic fall in exploration for gas following the U.S. shale boom.

In Europe, the last few years have seen a significant, albeit unsuccessful drive to replicate the U.S. using the same fracking techniques employed in North America. Juniors, such as San Leon Energy Plc (SLE:LSE; SLGYY:OTCBB), Aurelian Oil & Gas (which recently merged into San Leon) and 3 Legs Resources (3LEG:LON) have all capitalized on the plethora of unconventional gas resources in Europe and the continent's comparably high gas price environment.

In the U.K., the recent listing on the shale oil and gas exploration has brought renewed focus to exploration there. IGas Energy Plc (IGAS:LSE) has just announced that its licenses in Northwest England could hold between 15 and 172 trillion cubic feet (Tcf) of gas. Although that is a preliminary estimate, it is considerably higher than was previously contemplated.

Elsewhere around the globe, a very interesting company has caught my attention: Falcon Oil & Gas Ltd. (FO:TSX.V; FOG:AIM; FAC:ESM). It operates in Australia, South Africa and Hungary. It was recently admitted to London's Alternative Investment Market. While geographical diversification is a core aspect of Falcon's portfolio, the company has considerable conventional resource potential across all of its assets: The company holds 14.7 million acres in total.

Falcon benefits from relationships with well established partners, namely Hess Corp. (HES:NYSE) in Australia and Gazprom (OGZD:LSE; GAZ:FSE; GAZP:MCX; GAZP:RTS; OGZPY:OTC) in Hungary. Those alliances can help to carry the company through the initial phases and provide technical skills and financial resources. Falcon is embarking on an active work program through the end of 2014 alongside these strong industry partners. Additional transactions are expected to reduce the financial exposure of derisking its substantial portfolio. Considering our expectation that Falcon's near-term shale gas drilling in Hungary will be followed by a decision to drill five carried wells in Australia, we feel that Falcon's current share price undervalues its material potential within its asset base.

TER: When we talked last December, you were bullish on CBM Asia Development Corp. (TCF:TSX.V) —whose share price has fallen—and Tethys Petroleum Ltd. (TPL:TSX; TPL:LSE) —whose share price has risen. What is your current view on those two firms?

SW: I remain very bullish on both companies. CBM Asia has an active year ahead with a work program that is geared toward first-stage pilot production. The company is incorporating two pilot programs, one in the Barito Basin and the other in Central Sumatra, as well as dewatering activities at the Sekayu PSC and the Kutai West CBM PSC. Significantly, the production pilots are planned in areas where CBM Asia holds operatorship, thereby avoiding reliance on outside partners. In addition, the company's recent joint venture agreement to farm into Exxon's Barito Basin CBM blocks, as well as potential PSCs and joint studies in the Kutai Basin, is clearly significant. In our view, the deal offers a combination of technical and financial strength, as well as the operational efficiency that will be crucial in developing the basins. This deal unlocks the upside potential identified through initial data analysis. Our model calculates the potential for 9.7 Tcf net recoverable, which, if confirmed, could be transformational for CBM Asia.

Tethys Petroleum remains on track and the share price has performed in line with expectations following the company's farm out of its Tajik assets to Total S.A. (TOT:NYSE) and China National Oil and Gas Exploration and Development Corporation (CNODC). Tajikistan represents an entirely different proposition to investors, in our view. Tethys has a 28% effective interest in the Bokhtar PSC following the completion of the farm-out negotiation, which represents a significant proportion of the externally validated 27.5 billion barrel (27.5 Bbbl) recoverable prospective resource base.

Full details of the 2013-2014 program will be announced very shortly; however, we would expect 2013 to consist of a seismic survey and subsequent data interpretation followed by a deep exploration well in 2014. We would also expect further exploration and development drilling in Kazakhstan as the company continues to target their 1.3 Bbbl gross mean recoverable prospective resource base.

TER: Moving back across the pond, how would an increase in U.S. exports increase junior action in the Gulf of Mexico?

SW: Any increase in demand and a resulting shift in prices will invariably attract junior exploration. Nevertheless, the sheer cost involved in mounting a pure-play exploration program in the Gulf of Mexico is a barrier to entry. One company of note that I cover in the Gulf is Energy XXI (EXXI:NASDAQ). It entered the region in 2005 and purchased key assets from Exxon in 2010. The potential of U.S. exports has pushed the company to invest in the Gulf even more this year. The company budgeted a capex program of $750 million ($750M). Approximately 75% of the firm's fiscal 2013 budget targets development drilling, and 25% of the budget targets exploration drilling.

Energy XXI has a geographically focused portfolio with some of the largest margins in the industry. It is focused on developing acquired properties while ramping up a complementary exploration program designed to provide organic growth. Also, it has more than 120 million barrels oil equivalent (120 MMboe) in proved reserves. It is set to soon produce 50,000 barrels of oil equivalent per day, of which 70% is oil. The signs look good for this company.

TER: What is the international dynamic between the use of coal by utilities and the emergence of LNG as a cheap reliable energy source?

SW: The sudden abundance of cheap natural gas has dramatically changed the way that the U.S. produces and consumes energy. Modern natural gas-fired power plants produce much cheaper energy compared to coal plants. Burning natural gas, which is mainly methane, produces far less carbon dioxide than burning coal—a modern gas-fired power plant emits roughly two-fifths the carbon a modernized coal plant emits. Some economists say it's hard to overstate the significance of the sudden availability of cheap natural gas. In my opinion, it is the largest change in our energy system since nuclear power became part of the electricity grid 50 years ago.

However, applying simple economics, utilities might return to using more coal in the future as increased demand makes natural gas more expensive. And the developing countries are behind the U.S. in terms of replacing coal with gas. But the replacement trend is growing. Over the next 20 years, global demand for natural gas is expected to rise dramatically, fueled by rapid economic growth in Asia. With the development of LNG, many companies are positioning to take advantage of that emerging market.

TER: How much would the price of natural gas have to rise to make coal more attractive in the United States?

SW: That is a difficult figure to calculate. There are a lot of social and economic forces in play, including carbon emissions and climate change protocols that the government is trying to put in place. Governments could even prohibit the use of coal. In my opinion, gas prices could rise dramatically in the U.S., and gas would still be the preferred option over coal.

TER: What advice do you have for investors looking to enter or stay the course in gas-oriented firms?

SW: While oil and gas prices rise and fall, there is an overall resurgence in regional and global energy markets being driven by increased demand from the Asian economies, including China, India and Korea. The investment needs that accompany resurgence should set the stage for sustained merger and acquisition activity over the long-term. As for LNG, investors must consider the likely movement of supply and demand over time.

TER: Thanks so much, Sam.

SW: Thank you.

Sam Wahab began his career at PricewaterhouseCoopers (PwC), where he qualified as a prize-winning chartered accountant. On PwC's energy team, he specialized in assurance and transaction advisory. His clients included Royal Dutch Shell and JKX Oil & Gas. Following a spell in the oil and gas research team at Arbuthnot Securities, Wahab joined Seymour Pierce in 2011. He now heads up oil and gas equity research at Cantor Fitzgerald. His coverage includes companies with global operations on multiple stock exchanges.